Thursday, March 6, 2008

Large Gaps Higher In Uptrends vs. Downtrends


At the end of January I showed what happened when the market gapped substantially lower during uptrends vs. downtrends. Surprisingly to many, buying large gaps down in downtrends was far superior to uptrends. Tonight I thought I’d look at another side of this. How do large gaps up fare in uptrends vs. downtrends?

Once again I demanded a 0.75% gap for my trigger using the SPY. I then tabulated the results of buying the gap up at the open and selling it at the close. What I found may again surprise you.

When the market closes above the 200-day moving average, trying to buy a gap has been a losing strategy. Of the 123 instances I found looking back to 1994, only 57 had tacked on more gains by the end of the day. The rest finished down from their opening price. The net total movement of buying all these gaps up and selling them at the close would have been a loss of about 17.4% for the 123 trades.

Downtrends showed a different picture. Buying gaps up of 0.75% or more during downtrends was actually profitable. In this case, 58% of the 105 instances finished with the SPY closing higher than it opened. The net total of the movement from open to close was a gain of about 26% as opposed to the loss we saw above.

I suspect short-covering is a big reason that large gaps tend to spark additional buying in downtrends but not in uptrends. Stops get blown through overnight and when they see the market getting away from them, panic-covering ensues.

Regardless of the reason it appears when the market is below its 200ma the easy money is typically made not by fading the large gap up, but by looking to go long. Fading large gaps up appears to be more fruitful in uptrending markets than down. These results seem to go against conventional wisdom and provide another example of a lesson that many traders may need to “un-learn”.

2 comments:

Woodshedder said...

I believe the fade the opening gap play was popularized in Carter's Master the Trade or Altrucher's Trade like a Hedge Fund.

I cannot recall if there are any additional pieces to this setup outlined in the book.

Red Hue said...

Carter considers pre market volume on his gap plays...and if its too big a gap he'll pass I believe or limit exposure. He wants to see low premarket volume and then play the gap to fill.